Any payroll tax cut should be designed not to hurt lower-income workers

Under the tax cut package negotiated by President Obama and Senate Republicans, a one-year 2% payroll tax cut would be substituted for the extension of the Making Work Pay (MWP) refundable tax credit proposed in the President’s budget request for fiscal year 2011. Many liberals have objected to the payroll tax credit on political grounds because it potentially undermines the dedicated funding source for Social Security, but there is also a compelling economic argument against this tradeoff. While the payroll tax cut comes at a much higher price tag and would thus have a greater net impact on job creation, the cut would actually lower disposable income for all tax filers earning less than $20,000 a year.

Dedicating the revenue associated with the payroll tax cut to an expanded MWP refundable credit would address both concerns. Alternatively, if political constraints require a tax cut rather than a refundable credit, we recommend adding a “hold harmless” provision to the payroll tax holiday to protect lower-income earners from seeing their disposable income reduced. The “hold harmless” provision would be relatively inexpensive, carry a particularly high “bang per buck” (by increasing disposable income of those individuals with the highest marginal propensity to consume), and help alleviate the rise in poverty associated with the recession.

The MWP refundable tax credit — the largest tax provision of the American Recovery and Reinvestment Act — refunds 6.2% of earned income up to a maximum credit of $400 for individuals ($800 for joint filers). Making Work Pay also included a phase-out of 2% of income on earnings above $75,000 for income ($150,000 for joint filers), so individuals earning over $95,000 ($190,000 for joint filers) would not receive any credit.

The payroll tax cut, on the other hand, would temporarily reduce payroll taxes from 6.2% to 4.2% (on the employee side only) for all tax filers. The taxable earnings threshold for Social Security payroll taxes is currently set at $106,800—above which no Federal Insurance Contribution Act (FICA) taxes are charged—so the maximum credit under the payroll tax cut would be $2,136. Because of the higher cap and lack of a phase-out threshold for higher-income earners, the payroll tax cut would increase disposable income for almost all tax filers.

The payroll tax cut would, however, hurt individuals earning less than $20,000 relative to the MWP credit because of the slower phase-in rate and lack of refundability. For example, a tax filer earning $10,000 would see a $400 credit under MWP (having hit the maximum credit amount) but only a $200 credit under the payroll tax cut. The breakeven point for a lower-income tax filer would be $20,000, where the value of the 2% payroll tax cut would rise to the $400 maximum credit under Making Work Pay. Thus, compared to the president’s proposal to extend Making Work Pay, the payroll tax cut serves as a tax increase for all earners making less than $20,000.

Economic theory suggests that adding a “hold harmless” provision would see a very high “bang per buck” and would pump even more stimulus into an economy that desperately needs to create jobs. Econometric evidence is also supportive of the higher economic return on refundable tax credits than many other short-term countercyclical policies. Moody’s Analytics chief economist Mark Zandi estimates that the payroll tax holiday will see $1.09 in economic activity for every dollar spent, a less cost effective stimulus than the Child Tax Credit ($1.38), Earned Income Tax Credit ($1.24), or MWP ($1.17) refundable credits. By way of contrast, extensions of the Bush income tax cuts would generate only 35 cents on the dollar and the “accelerated depreciation” business expending credit would yield only 25 cents on the dollar. We estimate that the additional estate tax relief ($25 billion more expensive than reinstatement at the 2009 parameters) would have a much lower—indeed negligible—impact on economic activity and employment.

While many liberals would have designed a tax relief and stimulus package quite differently (particularly with regards to the estate tax), the projected economic impact of the package is nonetheless compelling in many respects. For instance, the Center on Budget and Policy Priorities (CBPP) estimates that the expanded EITC, the CTC, and the payroll tax cut will keep 2.4 million Americans—half of them children—out of poverty. Given that poverty climbed to a 15-year high of 14.3% in 2009 and is likely to climb higher in 2010, cutting the disposable income of working Americans earning less than $20,000 annually would unconscionably worsen poverty in America. CBPP estimates that continuing the refundable MWP tax credit instead of enacting a nonrefundable payroll tax cut would keep an additional 500,000 Americans out from under the poverty line.

Based on the Tax Policy Center’s distributional analysis of the two tax cuts, we estimate that a “hold harmless” provision for low-income workers would cost roughly $6.5 billion.[1] The Congressional Budget Office estimates that the payroll tax cut would cost $112 billion, so both the tax cut and the “hold harmless” provision could be funded under the $120 billion placeholder in the negotiated tax cut deal.

While costly extensions of the Bush tax cuts for the wealthy and additional estate tax relief may be the concessions to Republican lawmakers needed to move any additional stimulus, including middle class tax relief, there is no defensible reason to concede a tax hike on those earning less than $20,000. Short of replacing the entire payroll tax cut with a more progressive and stimulative refundable tax credit, a “hold harmless” provision would make for sound economic and social policy.

[1] This estimate is based on the difference between the average benefit under the Making Work Pay credit and the average benefit under the payroll tax cut for all qualifying “tax units” earning less than $30,000. Over the $20,000 to $30,000 income level, the average value of the MWP credit is $466, compared with $427 for the payroll tax cut, and the cost of the hold harmless would be only $614 million for this income level. Cumulatively, the cost of the hold harmless would be $6.3 billion for tax units with cash income below $30,000. A few tax units in the $30,000 to $40,000 income level would receive a larger benefit under MWP, but the average value of the payroll tax cut jumps to $600 whereas the average value of MWP increases only slightly to $481. We assume that the cost of the hold harmless for tax units in the $30,000-$40,000 income level would be very small, and we view the $6.5 billion total cost as a conservative estimate that would cover these additional tax units earning more than $30,000.